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- Scope 3 ‘Financed Emissions’ Calculation and Reporting
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Sustainable Finance Disclosures Regulation (SFDR) and EU Taxonomy: A New Era for Financial Transparency

Against the backdrop of a shifting global paradigm, the importance of ESG (Environmental, Social, Governance) has become more significant than ever. Financial institutions, investors, and businesses are all tuning in to the harmonized notes of sustainability. Central to this changing landscape is the Sustainable Finance Disclosures Regulation (SFDR) and the EU Taxonomy.

Launched in March 2021, the SFDR sets out rules for sustainability-related disclosures in the financial sector.

Deciphering the SFDR

The SFDR is an EU-led directive, underscoring the necessity for financial market participants and advisors to shed light on their approaches towards sustainability risks. With increasing recognition of the climate crisis and the associated financial risks, the European Union has spearheaded initiatives to redefine financial markets in the context of sustainability, in pursuit of the European Green Deal and the address Greenwashing practices. No longer is it adequate to merely assert sustainable investment practices; there’s a mandate for tangible, verifiable disclosure of sustainability risks and their integration into investment due diligence and decisions.

The SFDR applies to a wide range of entities, including asset managers, pension funds, insurance companies, and financial advisors.

Impact Reporting and Principal Adverse Impacts (PAIs)

Reporting entities are required to consider PAIs on sustainability factors, if in scope for the regulation. These are negative effects on environmental, social, or employee matters, respect for human rights, and anti-corruption and are defined as:

those impacts of investment decisions and advice that result in negative effects on sustainability factors (Regulation EU 2019/2088)

At the entity level: Firms must disclose information about their policies on the integration of sustainability risks in their decision-making process.

At the product level: Information about how products meet environmental or social objectives.

EU Taxonomy

The EU Taxonomy is a tool to help investors, companies, and issuers navigate the transition to a low-carbon, resilient, and resource-efficient economy. The taxonomy aims to define what is ‘environmentally sustainable’ by focusing on:

1. Climate change mitigation

2. Climate change adaptation

3. Sustainable use and protection of water and marine resources

4. Transition to a circular economy

5. Pollution prevention and control

6. Protection and restoration of biodiversity and ecosystems

The taxonomy provides detailed criteria (‘Technical Screening Criteria’) for each environmental objective, specifying performance thresholds that economic activities must meet.

Impacts on the financial sector and clients

1. Transparency and Reporting: Financial institutions are required to provide transparency about how they integrate sustainability risks into their investment decisions and advisory processes. This means disclosing potential adverse impacts of their investments on sustainability factors.

2. Product Classification: SFDR introduces a classification system for financial products based on their environmental or social objectives. Products are categorised as:

• Article 8 (products promoting environmental or social characteristics)

• Article 9 (products with a sustainable investment objective)

3. Reputation and Trust: With these transparency requirements, financial institutions have the opportunity to enhance their reputation and build trust with clients who are increasingly concerned about environmental, social, and governance (ESG) issues and aligning these values with their capital allocation decisions.

4. Risk Management: Financial institutions need to consider sustainability risks and their potential impacts on the returns of financial products. This leads to a more holistic risk assessment.

5. Operational Changes: Compliance with SFDR may require financial institutions to adapt their internal processes, operating models, data collection and management frameworks, IT systems, and documentation.

6. Cost Implications: While increased transparency and disclosure can lead to competitive advantages, they also come with implementation costs, especially in the early stages (e.g. onboarding resources, up-skilling portfolio managers and advisors etc.)

7. Product Innovation: The regulation might encourage financial institutions to design and offer more sustainable financial products to meet the rising demand.

8. Increased Scrutiny: As financial institutions disclose more information, there might be heightened scrutiny from regulators, investors, and the public on how sustainability risks are managed. A particularly risky facet of the regulatory rules is forward-looking statements in efforts to decarbonise portfolios.

9. Competitive Advantage: Institutions that effectively embrace and communicate their ESG strategies can differentiate themselves in an increasingly competitive market.

10. Integration with Other EU Initiatives: SFDR is just one piece of the EU’s broader sustainable finance action plan. Compliance and alignment with SFDR can better position firms to navigate other related regulations and initiatives.

In summary, while the SFDR presents challenges in terms of compliance, reporting, and operational adjustments, it also offers opportunities for financial institutions to differentiate themselves, address client demands, and position themselves for the future of sustainable finance.

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